The materiality madness and why definitions matter

Ashley Alder (Chairman of IOSCO) stated recently that the “ISSB climate standard will not ignore impact”. This relatively innocent statement has created confusion on whether this means a change in direction of the IFRS Foundation’s positioning on exclusive focus on financial materiality for their reporting on sustainability. 

This begs the question if the International Sustainability Standards Board will make the move to ‘double materiality’ – similar to the EU - and focus not only on financial risks and opportunities for the organisation but also on how the organisation’s activities will impact the economy, environment and people.

Presently, it appears like a tempest in a teapot as it is unlikely that the ISSB has the aspiration to arrive at true impact reporting. Existing disclosure guidelines upon which the ISSB draws - TCFD, Value Reporting Foundation, which includes SASB) and CDSB - all have exclusive focus on financial materiality for investor-based audiences. 

Ashley Alder’s comment emphasises that clarity is needed on what impact really means and how this translates into the idea of materiality in relation to sustainability reporting.

Back to basics

In the world of reporting, materiality is a key concept and has a part in both preparation of disclosures and verification by auditors. Materiality is utilised to ‘filter in’ information that is, or should be, relevant to users. Certain information is considered ‘material’ if it can influence decision-making of stakeholders regarding the reporting company. 

This short description denotes that materiality is not definitive and is subject to interpretation. What does matter is not only what is meant by information but, importantly, who are the stakeholders. Are they only financial decision-makers such as financiers and investors and financiers or do they also include the socioeconomic environment such as customers, communities, employees and suppliers?

The following question to ask is how to interpret influence. Should this be purely financial, regarding costs or compliance (i.e. value creation for the reporting organisation itself)? Or should it be viewed in terms of the impact on people, environment and the economy? The process of defining influence creates confusion around the concept of materiality.

The confusion surrounding materiality 

To clarify things from from the beginning, there are two primary directions of thought around materiality, in combination, constitutes the conception of ‘double materiality’:

We have recently seen a prolific growth of terms being introduced, in addition to more familiar concepts of financial and impact materiality, and like extended materiality, dynamic materiality, core materiality and nested materiality. These are meant to bridge the gap between financial and impact materiality, but it just adds to the materiality madness, unnecessarily complicating the idea behind the concept of materiality. 

Of the concepts mentioned above, the one heard most often is dynamic materiality. Based on the primacy of ‘financial materiality’ it has been extended by the idea of ‘pre-financial information’. The starting point is that some sustainability issues do not have a direct monetary impact on an organisation’s present financial value creation but could do so in the medium or long term. 

Stating that some information is dynamic rather than static blurs boundaries between financial and impact materiality and complicates the way in which substance should be given to sustainability disclosures. The concept of dynamic materiality is simply a postponement of double materiality where organisations should report on matters influencing enterprise value (financial materiality) and matters affecting people, environment and the economy (impact materiality).

The impacts of a company are or will become financially material over time. Without an understanding of these impacts, it will not be possible to obtain a complete picture of financially material issues that affect the company. Impact reporting is highly relevant in its own right as a public interest activity for many stakeholders. Impacts of a company matter and have to be disclosed even if the organisation or its investors do not consider them to be financially material, presently or in the future.

Under the umbrella of ‘double materiality’, financial materiality and impact materiality are the only relevant forms of materiality. Both perspectives are required in a two-pillar structure (for financial and sustainability reporting) with a core set of common disclosures and each pillar on an equal footing.

The current landscape and materiality

There are two sustainability reporting developments that are happening which take a different approach on materiality. 

1. The EU is creating the European Sustainability Reporting Standards (ESRS) which will be based on double materiality, for multi stakeholder audiences, including investors). The European Financial Reporting Advisory Group (EFRAG) and GRI are leading its co-construction efforts.
2. Standards for disclosure of sustainability-related financial information are currently being drafted by the IFRS Foundation (with which the newly established ISSB is charged with) and they will be based on financial materiality for investor audiences only.

Approaches of the EU and IFRS are complementary and not competing forces. Differing standards have different purposes for different audiences. Standards with the sole purpose of informing investors are built on a different concept from impact standards that inform broader groups of stakeholders. 

It is in the interest of all stakeholders to develop a corporate reporting system based on two pillars - for financial and sustainability reporting - with a core set of common disclosures and with each pillar on an equal footing. 

One set of standards globally is the ultimate goal and should underpin both the financial and impact materiality perspective. With cooperation and goodwill, we can rapidly progress on both these fronts - delivering improved reporting that fulfils the applications of materiality, and meets transparency needs of many stakeholders. The concept of stakeholder capitalism not being based on the concept of double materiality makes no sense at all.

If you have any questions or required a more detailed discussion, contact Lee Swan (Sustainability Solutions Lead at Emergent Africa) at lee@emergent.africa